Author: Jim O'Leary

It seems that the structural balance is going to be the primary target of fiscal consolidation in next week’s supplementary budget, thanks in part to the efforts of some of the contributors to this site, notably Philip Lane and Patrick Honohan. However, despite its obvious intellectual appeal, it is problamatical from an operational point of view: it is very difficult to estimate reliably. As a result, there is a fair amount of variation in current estimates of it for 2009, ranging from the lower bound of the ESRI’s 6-8% of GDP range to John McHale’s 9.6% in his post of March 30th.

Accordingly, all estimates of the structural deficit need to be treated with some caution. I think this is especially true of those that imply that a very small fraction of the prospective overall deficit for 2009 is cyclical in nature.

As any fiscal anorak will know, but perhaps not many normal readers, there are two main planks in the estimation of the cyclical (and hence the structural) element of the deficit: (i) the output gap and (ii) a measure of the sensitivity of the budget to the output gap. A word on each.

The output gap. The European Commission estimates that Ireland’s potential growth rate will be negative to the tune of 0.4% this year. This is surely a much lower figure than it is reasonable to use to represent the economy’s potential growth over the medium run. The ESRI’s latest estimate of the latter is 3%. Which one to use in calculating the output gap? If the former, it will mean a relatively small output gap and a correspondingly small estimate of the cyclical element of the deficit. Philip Lane has opted for this approach (see his post of March 26th). However, it can be argued that since the elimination of the structural deficit is properly regarded as a medium-term objective, it is the medium-term potential growth rate that should be used to estimate the output gap. The result is a bigger estimate of the output gap and a bigger cyclical component in the deficit.

The sensitivity measure. It has become commonplace to use 0.4 as the cyclical sensitivity co-efficient, implying that every 1% point change in the output gap changes the budget deficit by 0.4% of GDP through the operation of ‘automatic stabilisers’. The 0.4 is an OECD figure estimated on the basis of data for the 1980-2003 period. It is built up from a set of tax and spending elasticities with the overall tax elasticity computed as a weighted average of the elasticities of four different categories of tax, where the weights reflect the share of each in total tax receipts over the 1995-2004 period. An obvious point about this is that the composition of the 2008/09 tax take is different from that of this historical period.

A more important question is whether the elasticities so estimated accurately reflect the relationship between revenue and GDP in current circumstances. A case can be made for the proposition that the cyclical sensitivity of at least some categories of tax is higher than usual in the current recession. A very interesting comment from Niall on Patrick Honohan’s ‘Credit card sales’ post of March 31st sepaks to this point. He warns of a triple whammy undermining this year’s CT receipts, comprising (i) 2008 preliminary tax refunds; (ii) losses set back to 2007, and (iii) no preliminary receipts for 2009. In the OECD model, CT receipts are estimated to have an elasticity of 1.3. Does this chime with what’s happening out there?

To illustrate the difference that the above two points can make, consider the following arithmetic example. Assume a zero output gap in 2008, a volume decline of 8% in GDP and an overall budget deficit of 12 % of GDP in 2009. Now decompose that deficit into its cyclical and structural components using (i) a -0.4% potential growth rate and a sensitivity co-efficient of 0.4 and (ii) a 3% potential growth rate and sensitivity co-efficient of 0.5 (this being close to the OECD estimate of the EU average, by the way). In the first case, the cyclical/structural split is 3%/9%; in the second it is 5.5%/6.5%.

It seems that the intellectual underpinnings of the ICTU plan for economic recovery are to be found in the Swedish government’s response to their crisis in the 1980s. A Swedish dimension is no great surprise in itself: David Begg has long been an admirer and advocate of the Scandinavian model. He was on RTE’s Q&A on Monday night and in the context of the ICTU plan, referred to the writings of an economist who worked for Goran Persson, the then Swedish finance minister.

Curiously, more details emerged in this morning’s Irish Times in a discreet article secreted away on p.7 www.irishtimes.com/newspaper/ireland/2009/0218/1224241331376.html. According to the piece “the work of a Swedish economist who advised its government when its banking sector collapsed is being used by ICTU as the basis for its ‘social solidarity pact'”. The article goes on to name the economist concerned – Jens Henrikkson – and refers to a paper he published two years ago under the aegis of Bruegel, the Brussels-based think-tank (of Alan Ahearne fame).

I was intrigued that David Begg would identify a specific paper as the inspiration of the ICTU position and decided to check it out. I suggest that others check it out too. It is called “Ten Lessons About Budget Consolidation” and was published as part of the Bruegel Essay and Lecture Series in 2007. It can be downloaded (after a little bit of search activity) at http://www.bruegel.org/Public/Section.php?ID=1157

If David Begg is a big fan of this guy and the approach he advocates, there is a light at the end of the tunnel. Henrikkson’s first lesson is: Sound Public Finances are a Prerequisite for Growth; his second: If You Are In Debt, You Are Not Free. He recounts, inter alia, how the Social Democrat government of the day engineered across-the-board cuts in spending, including cuts in welfare benefits.

Henrikkson has quite a few things to say that The Two Brians could usefully take to heart. Some samples: “An ad hoc hodgepodge of measures will only have a limited chance of success” and “It is of great importance that the minister for finance is conservative when it comes to prognosis”.

The downside of all of this is that whatever intellectual debt the ICTU document owes to Henrikkson is not obvious from the document itself. But maybe what Begg is saying is: if you want to know where we really stand, as distinct from the public posture we have to take, you’ve got to read this other stuff too.

From the frontiers of knowledge (yes, it’s grading time again): “Fiscal contraction was first noticed in the 1960s by a man by the name of Fiscal and it was him who derived the short, medium and long run effects of it and how they would occur and the reasons for it…”

It all suggests that, as far as public sector pay is concerned, the commentariat is focused on quite the wrong question. It’s not whether there should be a public sector pay freeze, it’s how big the pay cut should be.